More on the Economics of ETH 2.0

Last month the ETH 2.0 public testnet Topaz was released, actively being developed by Prysmatic Labs. So now there is a lot more information about what ETH 2.0 is going to look like.

Note: I will use “ETH” to refer to ETH tokens on the current proof of work Ethereum chain and “BETH” to refer to ETH tokens on the proof of stake Beacon chain. This is only to make discussion easier not to inflame any separation.

ETH 2.0 Facts as of Now

It’s probably just easiest to list the currently known facts of ETH 2.0 in rough order of how the transition process works:

In Phase 0, anyone with ETH can send it to a smart contract which will lock the ETH forever, and generate BETH on the Beacon Chain

The conversion of ETH tokens (PoW) to BETH tokens (PoS) is a substitution and it is one-way, once you go from PoW to PoS you can’t go back, but the conversion is a 1:1 exchange rate

BETH can not be transacted on Beacon Chain until Phase 2, only staking of BETH is possible until then

BETH staking size is 32 BETH exactly, no more or no less

To stake you need to run a Beacon full node and a “validator client” which can have hundreds of “validator keys”, each of which must have 32 BETH exactly to stake

Once staked, BETH can not be unstaked until Phase 2

BETH stakers will have a return that is based on how many people are staking BETH

Rewards are disbursed every 6.5 minutes

Any converted BETH in same account in excess of 32 faces a penalty (to encourage staking)

Any BETH stakers who go offline or have issues validating will face a penalty

At Phase 2, BETH becomes just ETH, and the current ETH chain will have the ice age difficulty bomb that slowly makes it not viable, further incentivising people to convert ETH to the BeaconChain

These are the facts as they are currently known. And my interest is on the economics of how the new asset being created, a staked BETH, relates to the current chain token ETH and how various markets could emerge.

Chain Split Market

We have seen in the past the concept of the “chain split market” where an incumbent chain has a split and a new token is created from the ownership of the incumbent chain token.

As the split creates an additive token asset it becomes easy to then establish a prediction market for Incumbent Token and Split Token.

However, for ETH 2.0 this just would not be viable, for two main reasons:

The ETH 2.0 token is _not_ additive, it is a pure substitute

The exchange rate is 1:1 on the substitution at the point of ETH 2.0 launching and there are no consensus issues

Even though it is a one-way bridge and normal fork coins are also a 1:1 exchange rate, in this case, they are substitutes and there is wide consensus of ETH 2.0 becoming ETH and ETH conversion 1:1 means you could only freeze 1 ETH to convert it to 1 BETH (non-staking), rather than having 1 Future ETH and 1 BETH. Not a very interesting market where basically if someone creates a “Future BETH” (before the Proof of Stake chain is even live) and a market is made for current ETH vs. future BETH, it would not logically trade at above 1 ETH because anyone can just convert ETH to BETH when it’s available to stake. And it won’t trade below because anyone selling would basically just accept a loss because they go from ETH to future BETH to then less ETH, not very rational when the Beacon chain isn’t live and there is no staking benefit attached to the database entry.

As it currently stands I find it not viable for an exchange to offer a chain split market on ETH 2.0’s “BETH” before Proof of Stake is live without any staking of BETH.

Staking as a Service

One interesting thing that sticks out to me is the 32 ETH “exact” figure required for staking.

This prices out a significant number of ETH holders from being able to stake. And because Ethereum’s proof of stake model does not allow delegation, there emerges a different use case for centralized actors: staking as a service.

Obviously this requires trusting an exchange, where you would have to send ETH through a tool they offer to then credit you a database entry of BETH, and then they stake it and disburse rewards to you.

An example case would be a user who has 10 ETH. He loves Ethereum and wants to support the proof of stake transition but he can’t participate because he’s too poor. So he sends his ETH to Centralised Exchange X and converts it to 10 BETH. Centralized Exchange X stakes the BETH and disburses rewards (net of some convenience fee of course) to the user.

The user can not withdraw any BETH and has to trust the Centralised Exchange X to stake properly and to take care of his BETH until Phase 2 which may be a matter of years.

Also, for any users who have even thousands of ETH, the convenience factor of just sending the coin to exchange and letting them deal with the headache of running the full node and staking — makes it worth it for many.

As it currently stands I find it highly likely that multiple centralized exchanges will offer this feature.

Viability of Two Distinct Tokens

As mentioned before, the conversion will be a “one-way bridge” (ETH to BETH) and not a “two-way-bridge” (ETH to BETH and BETH to ETH). This makes the viability of two distinct ETH tokens more likely. However, the Ethereum developers have mitigated this by making BETH non-transferable, so that means you would not be able to move BETH from one exchange to another or even beyond your own wallet.

But what about the user above who staked 10 BETH? Maybe in a year, with Phase 2 still not completed, he has maybe 10.2 BETH and he wants out.

Obviously he can’t withdraw it, but what if the exchange themselves offered a market for BETH database entries vs. current ETH or BTC or USD. This would allow people to immediately jump into the asset of BETH which is staking and accruing rewards. The limitation here is that you again have to trust the centralized exchange and are stuck holding the BETH as database entries until Phase 2 is there. But this would allow people who have BETH “stuck” / staked with the exchange to get out and allow someone else to hold BETH.

The valuation of BETH in this context would consist of a number of factors:

Time value of money on the BETH due to locking period

Rate of return of the BETH staked by the exchange

Risk of exchange hack or exchange error in handling BETH staking

Arbitrage clause for 1 ETH = 1 BETH

Therefore, it is likely that if this market does emerge on some exchange, that BETH will trade at a discount to ETH, due to liquidity preferences of people who have locked their ETH with exchange and they want out.

I find it likely that some exchange will attempt to do this, which would set a price on Proof of Stake ETH before it is free to transact on the Beacon Chain.

Conclusion

The ETH 2.0 transition is very interesting because it is unlike any other “fork” or “airdrop” situation that has existed before. It is a pure conversion with a transition period whereby there are effectively two distinct tokens: ETH on the proof of work chain and BETH on the proof of stake chain. But due to how the incentives are crafted, no chain split market is viable before the ETH 2.0 launch, and there won’t be a proper market established for BETH until it is transferable in Phase 2. However, there will be opportunities for centralized exchanges to offer “staking as a service” to bring smaller ETH holders into staking and to allow others to stake in a more convenient way. By doing this, there is a possibility for a market to arise for BETH in the database entry form in walled gardens of exchanges that have to stake for users and corresponding BETH balances.